Consumer debt instruments, such as residential mortgages, are offered to homeowners in a range of structures. These vary by term (length of repayment period), interest rate type (fixed or adjustable), amortization of principal, and the number of up-front points paid.
One choice consumers typically have with respect to a consumer debt instrument such as a mortgage is the length of the repayment period or term. Thirty-year and fifteen-year mortgages are typical although ones with shorter and longer terms exist.
Most consumer debt instruments such as residential mortgages currently fall into two categories with respect to interest calculations: fixed-rate mortgages (FRM) and adjustable-rate mortgages (ARM). FRMs carry a fixed interest rate until they are fully amortized, unless they are paid off early because the home has been sold or the FRM is refinanced. ARMs carry an interest rate that adjusts periodically, usually but not necessarily on the anniversary date of the mortgage. In recent years, some home buyers have obtained hybrid mortgages which are a combination of FRMs and ARMs. Such hybrid mortgages continue for a period of time as FRMs and, at a predetermined time, are converted to ARMs on previously agreed terms. The newest trend includes mortgage “portfolios”, i.e., a combination of different types of mortgage loans under a single contract.
Additionally, consumers typically have a choice with regard to the amortization of the principal. Most mortgages are set up such that each payment made by the consumer pays off at least some portion of the principal. In recent years, interest-only mortgages have become more popular, particularly with younger home buyers or buyers seeking mortgages for investment properties. With interest-only mortgages, payments made by the consumer for the first several years are not applied to the principal and serve only to pay off the interest.
Yet another decision consumers must make when selecting a debt instrument is whether to pay up-front points in order to obtain a lower nominal interest rate. As an example, Table 1 below displays the terms of thirty-year fixed coupon mortgages offered by a large mortgage lender:
TABLE 1Selected Mortgage Products Offered byCountrywide Financial on Jun. 8, 2005PointsAnnual rate (%)APR (%)06.0006.0470.755.5005.6142.505.2505.524
The indicated annual percentage rate (APR) is the internal rate of return of the resulting cash flows. The APR is based on the condition that the mortgage remains outstanding for its full scheduled life, such as thirty years, and that the transaction cost at origination is 0.5%. In general, the APR includes any origination fees, discount points, and private mortgage insurance that may be part of the loan agreement. It is evident from Table 1 that a homeowner can reduce the APR of borrowing by paying up-front points.
Often times, consumers will rank mortgages and other debt instruments based on the conventional APR. However, conventional APR is not always an accurate indicator of the best mortgage choice, because the APR is based on the condition that the mortgage remains outstanding for the entire term. There are practical considerations that could significantly reduce the life of the loan. For example, the owner may need to relocate and sell the home prior to maturity of the mortgage. Additionally, the homeowner may decide to refinance the mortgage in order to take advantage of declining interest rates.
Presently, consumers have many choices of debt instruments when it comes to financing a home or other large asset. The term of the loan, type of interest rate, type of amortization of principal, number of up-front points paid, and the ability to combine several different mortgage types into a single “portfolio” mortgage creates a substantial number of mortgage structure possibilities. While each individual feature may have its appeal, such as whether to pursue a FRM or ARM, at present there remains no way of determining which combination of these factors will benefit an individual consumer most.
A further shortcoming of conventional APR is that it cannot be calculated for floating rate mortgages.
In addition, the consumer must factor in the risk of a particular mortgage structure (in the form of cash flow uncertainty, for example) when making a choice. Just as it is possible to earn high returns on investments with high risk, it is possible to pay low mortgage rates initially in a ARM, by taking on higher cash flow risk than for a FRM of comparable term.
Accordingly, there is a need for a more accurate indicator than conventional APR for determining which choice of consumer debt instrument is the most attractive based on the term, calculation of interest rate, amortization of the principal, the number of up-front points paid, and the risk tolerance of the consumer.